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U.S. banks are showing signs of strength despite being compelled to meet strict regulatory standards. Though it’s too early to be confident about the sector’s growth prospects, the progress seen in the first half of 2013 indicates a brighter future for those depending less on risky activities and resorting to other profit-making ways.

Nonstop expense control, sound balance sheets and lesser credit loss provisions are the key drivers of this advancement. Moreover, a favorable equity and asset market backdrop, falling unemployment, a progressive housing sector and flexible monetary policy have been making the road to growth smoother.

Yet top-line growth remains uncertain due to continued sluggishness in loan growth, pressure on net interest margins from the sustained low rate environment and less flexible business models owing to stringent risk-weighted capital requirements (Basel III standards). However, banks have been gradually easing their lending standards and trending toward higher fees to dodge the pressure on the top line.

Now that the interest rate environment is reversing, net interest margins are likely to improve and support the top line significantly. But revenues from mortgage fees will lessen as the boom in mortgage refinancing fizzles out. But whether the loss of fee revenue will be compensated by gains from interest rate spreads can be said only in the course of time.

However, it’s good to see that U.S. banks are taking legal and regulatory pressure in their stride, indicating their ability to encounter impending challenges. But with the economy in disarray, we don’t see the sector returning to its pre-recession peak anytime soon.

Overall, structural changes in the sector will continue to impair business expansion and investor confidence. Several dampening factors -- asset-quality troubles, mortgage liabilities and tighter regulations -- will decide the fate of the U.S. banks in the quarters ahead. But entering the new capital regime will ensure long-term stability and security for the industry.

Zacks Industry Rank

Within the Zacks Industry classification, U.S. banks are broadly grouped in the Finance sector (one of 16 Zacks sectors) and are further sub-divided into six industries at the expanded level: Banks-Major Regional, Banks-Midwest, Banks-West, Banks-Northeast, Banks-Southeast and Banks-Southwest. The level of sensitivity and exposure to different stages of the economic cycle vary for each industry.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more visit: About Zacks Industry Rank.

As a guideline, the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.'

The Zacks Industry Rank for Banks-Major Regional and Banks-Midwest is #26, Banks-West is #36, Banks-Northeast and Banks-Southeast is #40 and Banks-Southwest is #61. Considering the Zacks Industry Rank of the six banking industries, one could safely say that the near-term outlook for the group is 'Positive.'

Earnings Trend of the Sector

The broader Finance sector, of which U.S. banks are part, remains in excellent shape with respect to earnings. So far, 83.3% of the sector participants have reported second-quarter results, which have been very strong in terms of both beat ratios (percentage of companies coming out with positive surprises) and growth.

Both earnings and revenue beat ratios were pretty robust at 73.8% and 61.5%, respectively. Also, total earnings for the companies that have reported so far have shown an impressive 29.8% year over year increase on 8.6% growth in revenues. This compares with a substantially lower earnings improvement of 7.4% on 5.1% growth in revenues in the first quarter of 2013.    

The consensus earnings expectations for the rest of the year also depict a fairly strong trend. Though earnings growth is expected to slowdown to 8.0% in the third quarter, a stupendous improvement of 27.9% is expected in the fourth quarter. Overall, the sector is expected to register full-year growth of 16.1%.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.

Banks Show Potency

While 16.7% of the companies in the Finance sector are yet to come out second-quarter 2013 results, all major banks have already reported. Surging profits of the mammoths such as JPMorgan Chase & Co. (JPM - Free Report) , Wells Fargo & Company (WFC - Free Report) and Citigroup, Inc. (C - Free Report) were primarily backed by loan loss reserve releases. Similar to the last few quarters, banks set aside less money for bad loans this quarter. So, the core earnings power of the sector is still lacking.

Overall results of the mega banks show that top line still needs to improve for assured strength in performance. However, the positive developments of the sector and better macroeconomic elements helped most of the business segments of banks report improved results. A boom in investment banking in recovering financial markets led to good numbers.

The Federal Deposit Insurance Corporation (FDIC) has yet to release the second-quarter results for FDIC-insured commercial banks and savings institutions. But the progress seen in the first quarter is a clear growth indicator.   

FDIC-insured institutions earned $40.3 billion in the first quarter, up 15.8% from the year-ago quarter. This marked the 15th straight quarter of year-over-year earnings increase.

Besides contraction in provisions for credit losses and cost containment, marked recovery in the bond and equity markets and consequent growth in noninterest income helped most of the banks report higher-than-expected earnings. Given the solid results by the mega-banks in the second quarter, the improvement is likely to have further gained ground.

Bank Failures and Problem Institutions

During the second quarter of 2013, the failure of FDIC-insured banks increased to 12 from only 4 in the first quarter. However, 16 bank failures in the first half of the year compare favorably with 31 in the year-ago period.

The reduced pace of bank failures indicate continued improvement in the sector. Though fewer banks are expected to fail in 2013 compared to 2012 (51 bank failures), the industry is still to see an average failure of just four or five banks annually, which would indicate maximum strength in the industry.    

Moreover, as of Mar 31, 2013, the number of banks on the FDIC's "problem list" declined from 651 to 612. The continued decline in problem banks indicates a nonstop recovery of the industry. The latest positive trends in the industry are expected to further shorten the FDIC’s "problem list" for the second quarter of 2013.

Bottom Line Growth: Still a Challenge
We don't expect reduction in provisions for credit losses to significantly help earnings growth in the upcoming quarters, as the difference between loss provisions and charge-offs is gradually decreasing.

Banks will definitely try to look at other areas -- interest income, non-interest income and operating costs -- to maintain earnings growth, but there will be limited opportunities given regulatory restrictions and sluggish economic recovery.

Efforts to cut interest expenses and take additional risks to improve net interest margins could be marred by a still-flat yield curve. Further, shifting assets to longer maturities for strengthening net interest margin could backfire with the expected increase in interest rates.

Though rising interest rates will help improve net interest margins -- the key source of bank’s profitability -- revenues from mortgage fees will reduce significantly. The prolonged low-rate environment encouraged many people to refinance their mortgages, which resulted in hefty fees for banks. Now the rising interest rates will lessen mortgage refinancing and consequently fee revenues.

Conversely, increasing revenues through non-interest sources -- prepaid cards, new fees, higher minimum balance requirement on deposit accounts and pushing credit cards -- could be hampered by regulatory actions, economic volatility and soaring overhead. However, with a rebound in capital market activity, the propensity to invest in the market has increased, which may lead to more non-interest revenue sources. So, non-interest income can support total revenue to some extent.

Eventually, banks will have to take resort to cost containment through job cuts and reduced size of operations to stay afloat. So, any cost-cutting measure will act as a defense. The industry witnessed more than half a million layoffs over the last five years, and the story continues.

Balance Sheet: Recovery Underway   

Steady deposit growth from lack of low-risk investment opportunities is quite possible, but high charge-offs and delinquency rates plus weak demand could keep loan growth under pressure through the remainder of the year. Though banks are easing lending standards to accelerate loan growth, credit quality concerns are likely to mar the effort.

Moreover, though growth in gross domestic product (GDP) and reducing unemployment will help banks strengthen their balance sheets, expected unrealized losses on underlying securities due to rising interest rates will act as dampeners.

However, banks are trying to reorganize risk management practices to address potential solvency issues due to rising interest rates. Efforts are also being given to address asset-quality troubles by divesting nonperforming assets. However, we don't expect balance-sheet strength to return anytime soon.

Basel III: A Major Concern

The implementation of Basel III requirements from this year will boost minimum capital standards. But adjusting liquidity management processes will cause a short-term negative impact on the financials of U.S. banks.

This will ultimately make credit costlier and reduce employment. But a greater capital cushion will help larger banks withstand internal and external shocks over the long run.

Macro Backdrop Still Uncertain

Improved economic data such as higher consumer spending and GDP, improving housing market and declining unemployment rate point towards optimism, but the current low-rate environment and an expected increase show a bumpy road map toward growth.

The European debt crisis, which is still not over, could make the situation worse. Though U.S. commercial banks appear to have significant direct and indirect exposure to Europe, potential costs are expected to be manageable. There are some signs of hope, but if the crisis deepens further, global capital markets will face a big blow, and the U.S. will not go unscathed.


Though improved performances by banks seem already priced in and significant concerns remain, the sector is unlikely to disappoint investors in the upcoming quarters.

Specific banks that we like with a Zacks Rank #1 (Strong Buy) include BankUnited, Inc. (BKU), Enterprise Financial Services Corp. (EFSC), First Interstate Bancsystem Inc. (FIBK), East West Bancorp, Inc. (EWBC), Glacier Bancorp Inc. (GBCI), Metro Bancorp, Inc. (METR), OFG Bancorp (OFG), Webster Financial Corp. (WBS), Farmers Capital Bank Corporation (FFKT), Virginia Commerce Bancorp Inc. (VCBI) and Prosperity Bancshares Inc. (PB).

Stocks in the U.S. banking universe with a Zacks Rank #2 (Buy) currently include JPMorgan Chase & Co., Wells Fargo & Company, Citigroup, Inc., Comerica Incorporated (CMA), State Street Corporation (STT), KeyCorp. (KEY), BofI Holding, Inc. (BOFI), TriCo Bancshares (TCBK), Center Bancorp Inc. (CNBC), Community Bank System Inc. (CBU), Synovus Financial Corporation (SNV), City Holding Co. (CHCO) and First Financial Bankshares Inc. (FFIN).


Difficulty in liquidity management due to regulatory restrictions will restrict top-line growth of banks in the quarters ahead.

Specific banks that we don't like with a Zacks Rank #5 (Strong Sell) include Eagle Bancorp Montana, Inc. (EBMT), CNB Financial Corp. (CCNE), Financial Institutions Inc. (FISI), Malvern Bancorp, Inc. (MLVF), First Community Bancshares, Inc. (FCBC) and Peoples Financial Corporation (PFBX).

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